Although there have been relatively few liquidations during the pandemic crisis, this can be attributed to forbearance and government supports. Given the unprecedented drop in company revenues and the high level of fixed costs of many companies, the level of insolvencies is expected to accelerate significantly in the coming months as many “zombie” or insolvent companies, which are still nominally operational are forced into restructuring or bankruptcy. However, there are many more that will need to be monitored very carefully due to the emergence of new accounting and lending trends such as “material uncertainty relating to going concern” and the use of historic data for calculating current financial covenants.
Material Uncertainty Relating to Going Concern
Accountants and company directors may be put in a very difficult position due to existing accounting regulations. According to the current accounting standards (Financial Reporting Standard (FRS) 102), the financial statements need to be prepared on a “going concern basis” unless management intends to liquidate the business or cease trading within 6 months. A going concern is one where the financial accounts are prepared on the assumption that the entity is a going concern and will continue its operations for the foreseeable future. When the use of the going concern basis of accounting is appropriate, assets and liabilities are recorded on the basis that the entity will be able to realise its assets and discharge its liabilities in the normal course of business.
FRS 102 states that when management is aware of material uncertainties related to events or conditions that cast significant doubt upon the entity’s ability to continue as a going concern, the entity shall disclose those uncertainties. If boards identify possible events or scenarios that could lead to corporate failure, then these should be disclosed, but they may take account of realistically possible mitigating responses open to them.
The inclusion of a “material uncertainty relating to going concern” section in the annual financial statements does not mean that the company is not a going concern. It means that the directors have concluded that there is a material uncertainty about the company’s future operations and that the auditors agree with that judgement. The directors will have made clear, transparent disclosures in the financial statements regarding the nature and implications of the material uncertainty.
Regulators are hoping that shareholders, lenders and the financial media will be aware of the meaning of any qualifications or caveats and be aware of the implications. Although insolvencies are expected to increase rapidly, not all companies who get a modified or qualified audit opinion, as a result of COVID-19, are expected to fail.
The Lenders Dilemma
There have been various media reports of borrowers in danger of breaching their lending covenants as the unprecedented plunge in revenues causes problems for financial covenants. Punch Taverns (the pub chain) amended its securitisation documentation which allows for the submission of the equivalent 2019 historic data for EBIDTA based financial covenant calculations due to pub closures due to COVID-19 in 2020. Without this amendment, Punch Taverns would breach its financial covenants. The lenders seem to accept these types of measures, as they are seen as temporary and give the companies a chance to recover from the earnings shock. The alternative is a messy default in a very uncertain market where any asset sales will be at very distressed levels.
Live Nation Entertainment has announced that it has amended its credit agreements and will use 2019 earnings figures to calculate its net leverage covenant from the fourth quarter of 2020 until the second quarter of 2021 which it claims will give it “the flexibility to manage its business through the disruption it will experience in 2020.”
Financial covenants are designed to protect lenders in case of a deterioration in the financial condition of a borrower. The current trend to relax or effectively suspend covenants because of the current economic turmoil creates a dangerous precedent and indeed may come to be considered the new “extend and pretend” if it becomes more widely adopted!
A Return to Fundamentals
Analysing company accounts will once again become a critical skill. An ability to read financial statements and understand the numbers, but to do so in the context of the macroeconomy will be key to gaining critical insights into business actual performance and their future potential. It will be vital to recognise whether companies are indeed a going concern or if a company is really as strong as its financial covenants may suggest!